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The information provided on this site is not directed to any United States person or any person in the United States, any state thereof, or any of its territories or possessions.

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Access to this site is restricted to Non-U.S. Persons outside the United States within the meaning of Regulation S under the U.S. Securities Act of 1933, as amended (the "Securities Act"). Each person accessing this site, by so doing, acknowledges that: (1) it is not a U.S. person (within the meaning of Regulation S under the Securities Act) and is located outside the U.S. (within the meaning of Regulation S under the Securities Act); and (2) any securities described herein (A) have not been and will not be registered under the Securities Act or with any securities regulatory authority of any state or other jurisdiction and (B) may not be offered, sold, pledged or otherwise transferred except to persons outside the U.S. in accordance with Regulation S under the Securities Act pursuant to the terms of such securities. None of the funds on this website are registered under the United States Investment Advisers Act of 1940, as amended (the "Advisers Act").

One of the most popular themes in our blog posts this year has been that of small caps. Here, we look at how our dividend index methodology connects with the way Warren Buffett looks at potential acquisitions, key aspects being:

Businesses earning good return on equity (ROE) while employing little or no debt

The key phrase is “businesses earning good returns on equity while employing little or no debt.” However, the quality discussion within equity investing has a long history, and Warren Buffett certainly isn’t the only one to mention it.

Benjamin Graham’s Quality Criteria
One of Warren Buffett’s teachers, Benjamin Graham, who is known as one of the fathers of value investing, also had a rigorous focus on quality traits. Many focus on Graham’s criteria for finding inexpensive companies, but he was at least equally focused on attributes of quality, if not more so.

“Adequate” enterprise size, as insulation against the “vicissitudes” of the economy

Strong financial condition, measured by current ratios that exceed 2 and net current assets that exceed long-term debt.

Earnings stability, measured by 10 consecutive years of positive earnings

A dividend record of uninterrupted payments for at least 20 years

Earnings-per-share growth of at least one-third over the last 10 years

Fama-FrenchOperating ProfitabilityFactor

Research done by Kenneth French and Eugene Fama arrives at a similar place. In their research piece “A Five-Factor Asset Pricing Model” from September 2014, they cite operating profitability, defined as annual revenues minus cost of goods sold, interest expense and selling, general and administrative (SG&A) expenses, all divided by book value of equity. Note, this is similar to Buffett’s criteria above: a company earning a good return (profits) on its equity (book value)—in other words, a high ROE. Arranging the U.S. market into quintiles based on operating profitability further emphasizes that high-quality stocks have won over longer holding periods.

The Spectrum of Operating Profitability Quintiles from June 30, 1963, to June 30, 2015

Top Two Quintiles Outperformed the Market:We saw the top two quintiles outperform the market on two fronts—average annual returns andSharpe ratio. In other words, this outperformance was not achieved with a significant increase in risk.

Grantham on Why Quality May Outperform over Long Periods
One of the long-standing investment practitioners of quality investing has been Jeremy Grantham’s firm, GMO. In a paper written in 2004[3], GMO wrote of quality firms:

“… even though many of these corporations tend to generate high profits year after year, they are systematically underpriced because they lack volatility. Instead of overpaying for these companies, as finance theory would suggest—given their low risk profile—shareholders in fact do just the opposite: they underpay. The result is that investors in high-quality companies get to forge ahead with 15+% returns year after year without overpaying. Of course, in any given year, low-quality stocks can and do stage rallies and high-quality stocks can underperform. But the high-quality stocks have always won over longer holding periods. No matter what metric is used to identify quality stocks—leverage, profitability, earnings volatility or beta—high-quality stocks have beaten out low-quality stocks.”
In other words, the desire to try to find that “next big thing” tends to exert so much power over the investment psyche that focusing on quality companies has, at least historically, been one avenue through which to achieve outperformance.
At WisdomTree, we also believe that focusing on quality factors through rules-based processes can be a compelling investment strategy over the long term. Our SmallCap Dividend strategies are a prime example of this, combining a quality tilt, through the cash dividends weighting methodology, with the natural growth element of small cap stocks. These fundamental factors have contributed to the outperformance of our SmallCap Dividend strategies relative to market-cap weighted peers (a recap on the performance of our SmallCap Dividend Indices can be found here).
Investors sharing this sentiment may consider the following UCITS ETF:

This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, its officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.

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